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29.1 Adding Inflation to the Model - Coggle Diagram
29.1 Adding Inflation to the Model
explaining how constant inflation exists, and to look at it we need to understand role of
inflation expectations
such expectations give us more complete explanation of why costs and prices change → excess demand/supply due to output gap
Why Wages Change
main emphasis = general level of wages in the economy and the role played by broad macroeconomic forces
↑W → ↑unit costs b/c technology is constant
; therefore
↑W → ↑unit costs → AS curve shifting up; when ↓W → ↓unit costs → AS curve shifting down
Wages and the Output Gap (
cause AS curve to shift
)
three propositions about how changes in nominal (or money) wages are influenced by the output gap:
The excess demand for labour that is associated with an inflationary gap (Y>Y*) puts upward pressure on nominal wages
The excess supply of labour associated with a recessionary gap (Y<Y*) puts downward pressure on nominal wages, though the adjustment may be quite slow
The absence of either an inflationary or a recessionary gap (Y=Y*) implies that demand forces are not exerting any pressure on nominal wages
NAIRU
(Non-accelerating inflation rate of unemployment) →
is unemployment rate when real GDP is equal to potential Y (Y=Y*);
designated by potential U; NAIRU is not zero, b/c even during Y=Y*, there is frictional and structural unemployment present
WHY? BECAUSE
output gaps and NAIRU are inversely related with each other
; so if we are in recessionary gap, unemployment rate > NAIRU, in an inflationary gap, unemployment rate < than NAIRU
when Y>Y*,
the
unemployment rate
will be
less than NAIRU (U<U*)
(excess demand for labour and ↑W)
;
when
Y<Y*
,
unemployment rate
will
exceed NAIRU (U>U*)
(excess supply of labour and ↓W)
structural unemployment → unemployment due to mismatch b/w structure of supplies of labor (jobs) and structure of demands for labor (workers)
frictional unemployment → unemployment due to turnover of labor (people getting, quitting, and getting fired from jobs)
*nominal wages tend to react to various pressures on demand; can be stated in terms of relationship b/w actual and potential GDP or in terms of relationship b/w actual unemployment rate and NAIRU
Wages and Expected Inflation (
cause AS curve to shift
)
expected inflation gets "
built in
" to wage demands → seen as a self-fulfilling prophecy (you get what you expect); this holds real wages constant b/c nothing is improving or decreasing – if everyone moves the same way, there isn't any change
Causes of expected inflation
Backward-looking
; people will look at history repeating itself, e.g. low inflation in Canada last year, so low inflation in Canada next year
Forward-looking
; making "rational expectations" based on relevant information out there; e.g. if BOC announces 4% inflation (rather than 2%), than people adjust expectations to that;
leads to quick changes
Expectation Effect = ↑Pe → ↑W
; Pe = price expectations;
↓u →↑W
as long as people
expect
prices to rise, their behaviour will put upward pressure on nominal wages
Overall Effect on Wages
Δ in nominal wages = output gap effect + expectational effect
;
what happens to wages is the
net
effect of the two forces
; depending whether expectational effect/output gap effect is (+) or (-), determines wages outcome whether it's (+) certain % or (-) certain %
From Wages to Prices
*The net effect of the two macro forces acting on wages – output gaps and inflation expectations – determines what happens to the AS curve
if net effect of output-gap effect and expectational effect is to ↑W → ↑AS curve (right;↑W = ↑productivity = aggregate supply ) → ↑P → ↑W (
inflationary
)
if net effect of output-gap effect and expectational effects is to reduce wages → ↓AS curve (left; ↓W = ↓productivity = ↓aggregate supply) → ↓P → ↓W (
deflationary
)
we can look at decomposing inflation into two component parts:
output-gap inflation
, and
expected inflation
;
HOWEVER, AS curve can shift for reasons unrelated to changes in wages → e.g. supply-shock inflation
(exogenous) (e.g. Δ in prices of materials used as inputs in production → oil)
ALL 3 CAUSE AS TO DECREASE, SHIFT UP, LEFT (INFLATIONARY PRESSURES)
actual inflation = output gap inflation + expected inflation + supply-shock inflation
Constant Inflation
main definition: actual inflation = expected inflation
; e.g. inflation rate is 2% per year and has been 2% for several years; inflation doesn't change for several years (backward looking) so actual inflation is same as ones in past (forward looking into present inflation now)
CONSTANT INFLATION (Y=Y*) OCCURS WHEN
there is NO gap inflation or supply shock inflation
; SIDE NOTE, inflation rates are being kept stable by Bank's monetary policy being just expansionary enough to accommodate growing money demand (expansionary = ↑money supply)
rate of monetary expansion, rate of wage increase, and expected rate of inflation are all consistent with the actual inflation rate
; e.g. expected 2% rate of inflation = rate of wages increases by 2% (AS curve shifting up at 2%) → intersection of AS and AD curves must be shifting up at 2% rate for expected inflation to be actual inflation → this requires AD curve to shift up at same 2% rate (Bank's monetary expansion) → NO OUTPUT GAP INFLATION (Y=Y*)
KEY POINT = NO OUTPUT GAP effect operating on wages
when central bank increases money supply at such a rate that expectations of inflation end up being correct, it is add to be
validating
those expectations
*DEFLATION ASPECT
fear of deflation = causing decline in economic activity; common argument → firms and consumers delay their spending b/c prices are low → leftward shift of AD curve → decline in real GDP
OPPOSITE VIEWS TO COMMON ARGUMENT:
1) deflation as a result of recession in economy rather than a cause of an economic events; e.g. deflation in Great Depression was due to 1929 stock-market crash, widespread bank failures, inappropriate monetary and fiscal policies, etc. LEADING TO AD curve shifting left = decline in real GDP
2) when deflation is through small % numbers like 1 or 2, fear that buyers will delay their purchases b/c of deflation, thus causing a recession isn't that important... b/c no fundamental danger to economy
in OPPOSITE CASE where inflation increases 1%-2% → economy can operate with Y=Y
(constant inflation where rate of monetary expansion, rate of wage increase, and expected rate of inflation are all consistent with the actual inflation rate;
for deflation of 1%-2% same actions would be taken* (I think?)